This site uses cookies to store information on your computer. Some are essential to make our site work; others help us improve the user experience. By using the site, you consent to the placement of these cookies. Read our privacy policy to learn more.

S Corporation Reasonable Compensation

An ongoing area of focus for the IRS
is whether the compensation paid to a
shareholder-employee of an S corporation is
reasonable. A recent district court decision
highlights the employment tax risks to S corporations
that are found to have paid unreasonably low
compensation to shareholder-employees while making
distributions to the same individuals.

The
considerations for an S corporation are much different
from those of a C corporation. In the case of a
closely held C corporation, the IRS is often concerned
with whether the compensation paid for personal
services rendered by an employee-shareholder is
excessive and is being used to avoid a second level of
tax in the form of a dividend distribution. In the
case of an S corporation, the IRS believes that
employee-shareholders, particularly those who provide
professional services, have an incentive to draw a
minimal salary in order to reduce their payroll tax
liability.

These shareholder-employees would
prefer to take a tax-free distribution of funds from
the S corporation in lieu of withdrawing the funds in
the form of additional salary. The
employee-shareholder is already paying tax based on
his or her marginal ordinary income tax rates, whether
or not the S corporation distributes the income to the
shareholder. In many cases, the actual distribution
does not result in additional federal income tax
because the shareholder will have sufficient tax basis
in the stock to absorb the distribution. Thus, by
seeking to recast compensation as a tax-free
distribution from the S corporation, the employee’s
wages are reduced, income goes down, but taxable
income from the S corporation is increased by a
comparable amount. The net effect on the shareholder’s
income is zero or negligible. However, even though
taxable income remains the same, there will be less
payroll tax liability to the S corporation as well as
to the employee-shareholder.

The IRS has the
ability to recharacterize distributions to the S
corporation employee-shareholder as wages for
employment tax purposes. In Rev. Rul. 74-44, the IRS
ruled that distributions that two
employee-shareholders arranged to receive instead of
compensation for services they performed were deemed
wages and were therefore subject to FICA, FUTA, and
federal income tax withholding. The revenue ruling
described a situation in which there was a clear
avoidance motive, as distributions were made to
compensate the shareholder-employees who received
minimal salaries in that year. Several courts have
confirmed the IRS’s ability to increase the employment
tax obligations of S corporations under this theory.
In a recent case, David E. Watson,
P.C., No. 4:08-cv-442 (S.D. Iowa 12/23/10), the
court similarly ruled in favor of the IRS.

The
issue in this case was whether David Watson’s salary
paid by the taxpayer, a professional corporation that
elected to be taxed as an S corporation, for 2002 and
2003 was reasonable. Watson was the sole shareholder
and employee of the professional corporation, and the
professional corporation was a member of an accounting
firm. Watson was a CPA with more than 20 years of
experience who specialized in partnership taxation.
During the 2002 and 2003 tax years, he provided
accounting services to the related accounting firm
through the professional corporation. Watson received
only $24,000 in salary subject to the required
employment taxes, while he received substantially
larger distributions of profits totaling approximately
$200,000 and $175,000 in those years.

The
district court found that his stated salary of $24,000
for 2002 and 2003 was not reasonable. Based on the
specific facts and circumstances, the court found that
an annual salary of $91,044 was reasonable, and it
therefore reclassified $67,044 in distributions to
wages and required the taxpayer to pay employment
taxes on the additional salary amounts each year, as
well as interest and penalties.

The court set
out to obtain comparables for what other businesses
paid for similar services after taking into account
Watson’s training and experience as a tax
professional. The fact that a professional with 20
years of experience was essentially being paid
entry-level compensation particularly seemed to
influence the court. It concluded that an employee of
Watson’s stature, experience, and earning power is
clearly worth more than the $24,000 salary actually
paid, as seen by the significant profit distributions
he took in lieu of salary.

In advising clients,
tax practitioners often seek to provide more specific
guidance to determine how much compensation an S
corporation should pay an employee-shareholder in
order to reduce or eliminate the risk of
recharacterization of distributions as wages. The IRS
has provided some guidance in Fact Sheet 2008-25 (August
2008). In that document, the IRS states that there are
no specific guidelines for reasonable compensation
within the Code or regulations and that each case is
different based on the independent factors as well as
the specific nature of the case. However, FS-2008-25
explicitly states that S corporations should treat
payments for services to officers as wages and not as
distributions of cash and property, unless they
perform no or minimal services. Although there is no
specific guidance to determine whether compensation is
reasonable, the fact sheet lays out the following as
factors that the courts have addressed:

Training and experience;

Duties
and responsibilities;

Time and effort
devoted to the business;

Dividend
history;

Payments to nonshareholder
employees;

Timing and manner of paying
bonuses to key people;

Payment by
comparable businesses for similar services;

Compensation agreements; and

The
use of a formula to determine compensation.

The Watson decision
serves as a reminder that it is important to consider
a variety of factors in establishing reasonable
compensation levels for shareholder-employees of an S
corporation and why it is so important to closely
monitor specific facts and circumstances when
determining whether a compensation level is
reasonable.

EditorNotes

Kevin Anderson is a partner, National Tax Services,
with BDO USA, LLP, in Bethesda, MD.

For
additional information about these items, contact Mr.
Anderson at (301) 634-0222 or kdanderson@bdo.com.

Among CPA tax preparers, tax return preparation software generates often extensive and ardent discussion. To get through the rigors of tax season, they depend on their tax preparation software. Here’s how they rate the leading professional products.

Don’t get lost in the fog of legislative changes, developing tax issues, and newly evolving tax planning strategies. Tax Section membership will help you stay up to date and make your practice more efficient.